There is a persistent belief that large amounts of short selling will put a weak company over the edge-even drive it into bankruptcy.
Is there any hard proof that supports this?
As far as I know, it becomes interesting to “short” a stock (see in anticipation of a price decline), when:
-investors see a future of greatly diminished earnings for the firm
-large amounts of the stock are held by short-term investors
(worst case) inside information about disasters becomes common knowledge
I see “short selling” as normal speculation-only that the sellers see a price decline instead of an increase.
The most recent example I remember was the case of ENRON. As we now know, the management of ENRON was falsifying its financial data-they were hiding losses and making it appear that the firm was profitable. A leading investment firm checked their financial statements, and concluded that the firm was losing money-they then shorted massive amounts of Enron stock-they made a fortune, and Enron went bankrupt (and a lot of Enron executives went to jail).
So is shortselling an indication of bad management, or does it actually cause firms to fail?
The problem with coming up with a concrete example is that it’s difficult (or impossible) to say if a company was doomed to fail and that short-selling just accelerated the inevitable or if the same company would have survived if there hadn’t been any short-selling.
But the theory is reasonable: Anything that makes the company look weaker (like a sharp drop in stock price) will make it more expensive for the company to borrow money which in turn can make the company weaker.
Interesting. I’d assume (or hope!) that such decisions are based on market cap and not on share price per se, because a company can split or reverse-split their shares and make each one worth an arbitrary amount of money, just like the US Government could create a “New Dollar” that was worth 100 old USD and automatically convert people’s money over. Just because you now have one unit of something rather than 100 doesn’t mean that the unit you have is of lesser value, because the units are arbitrary, just like 32 degrees F isn’t actually hotter than 0 degrees C.
Anyway, are decisions actually made using this data?
E.g. :
Banker: “I’m sorry, your market capitalization just isn’t high enough for a 1 million dollar loan, try again next year.”
At the very least, a (permanent) drop in stock price affects a company’s ability to raise funds by issuing stock. If my stock price drops by 50%, I need to issue twice as many shares to raise a given amount of money. And if a stock drops far enough in price, it could get delisted from an exchange, for example.
But in a more general sense, a fall in stock price can be a signal that the person selling the stock knows something about the health of the company that you don’t. It might be a false signal, of course, but if a company is on the bubble in terms of short-term health to begin with, that might be enough to reduce the market’s confidence past the point of no return.
I took “like a sharp drop in stock price” to be shorthand for a fall in market capitalization, without having to expend unnecessary verbiage on the nitpick that one can also have a sharp drop in stock price when you perform a stock split.
They are based on (in part) market cap, which a split does not affect. Market cap is the price per share multiplied by the number of shares. This is (at least approximately ignoring information effects) the same before and after a split – after a reverse 2-for-1 split, the number of shares will halve, and the price per share will double.
It is quite reasonable to base loan decisions on market cap, and short selling can affect market cap if the presumed information in short sales is bad news as it likely would be if insiders were short selling.
This is what killed Enron (or, at least, what caused it to implode in a matter of weeks rather than facing some longer-term restructuring or bankruptcy). When market value fell, they no longer had the necessary collateral for loans. Here’s an excerpt from Wikipedia, with my key point highlighted:
The ability to issue shares to cover loans is absolutely a criteria that banks would weigh heavily in making their lending decisions. (It is, of course, not the only criteria. They’ll also weigh income, debt ratios, other types of collateral, etc.)
While a lot of short selling could be meaningful, for it to pay off, the company needs to have fundamental problems in order to fail. If a bunch of people short an otherwise healthy company, it only means they believe the stock will drop. But the short selling is unlikely to panic investors.
There’s a difference between short-selling and a drop in stock price. When people short a stock, they hope and expect the stock price to drop. But it might not. Plenty of people have been burned by short-selling stocks that continued to go up.
We’ve had this discussion a few times now. There is no shortage of companies who have complained about short sellers trying to manipulate their stock price, etc. Overstock.com was quite a famous example. Same with Lehman. But in general companies getting tanked by shorts have serious issues. Berkshire Hathaway isn’t in any danger of collapse when people short it (and plenty of people do/have. I personally think they’re insane but there you go).
That said, shorts driving the price of you stock down can screw a company a few ways. It increases the cost of capital in many, many different ways as some other posters have pointed out. It can also become a compensation issue, as your employees may want greater pay since the value of their company stock is decreasing, or they might just leave. It can also make you more vulnerable to a takeover. Generally speaking it is a sign of the health of the company and your business partners might be reluctant to engage with a company that seems like it’s on the way out.
There’s no doubt some manipulation but in general short sellers add contrarian voices to the market. They’re betting their money and telling the world that something is worth less than is commonly believed. When companies fail, it can be hard to tell how much was prophecy vs inciting the mob, but it only works if they can convince others they are right, in which case maybe they had a point. But they can be wrong like everyone else. Bear traps are a time honored way of losing an absolutely insane amount of money very quickly. You can lose your entire investment if you bet long and are wrong, but that’s it. There’s no theoretical limit to your loses if you bet short and get caught in a bull market.